Asset Allocation Strategies - Assaults on Modern Portfolio Theory
Asset allocation (modern portfolio theory), that is, diversification of investments into non-correlated asset classes, is a core principle espoused by many financial advisors. The core idea is that having non-correlated assets reduce risk and maximize returns.
But, what is now happening is that previously uncorrelated asset classes are now becoming more correlated! The core idea of asset allocation is unchanged, but, it seems that commodities, hedge funds, and small cap stocks, which have been touted as good diversification assets are now much more correlated with the S&P 500 than they used to be. This makes what was a previously low risk diversified portfolio a little more risky.
According to this Fortune article, the correlations of various assets has changed from February 2000 to February 2006:
At the 2006 Berkshire Hathaway annual shareholders meeting, both Warren Buffett and Charlie Munger expressed their dislike of modern portfolio theory. They also strongly disliked the views of the wizard of Wharton, Jeremy Siegel. In fact, Charlie Munger called it assinine! Strong words from some of the most respected investors in the world. They would rather buy good solid companies with predictable earnings. Well, it's worked for them! I can see their point somewhat- if you want to maximize your returns, just pick the best companies, instead of diluting your investments with companies or assets that are not as good. The problem is, a lot of random events cause unexpected things to happen. In addition, for many people who do not live for reading company reports and balance sheets, it's impractical to expect someone to do the level of research needed to select the best companies. Maybe if Warren would publish a book about how he values companies, that would help out some of the rest of us :)
Diversification and asset allocation will probably not give you the highest possible rate of return, but will give you a reasonable return with reasonable risk. Nevertheless, we should all be open to criticisms of popular investing strategies, as often what works for one time period ceases to work for another. Here's an excellent article discussing flaws of MPT. And here's another article on the criticisms of MPT.
But, what is now happening is that previously uncorrelated asset classes are now becoming more correlated! The core idea of asset allocation is unchanged, but, it seems that commodities, hedge funds, and small cap stocks, which have been touted as good diversification assets are now much more correlated with the S&P 500 than they used to be. This makes what was a previously low risk diversified portfolio a little more risky.
According to this Fortune article, the correlations of various assets has changed from February 2000 to February 2006:
Asset classes 2000 2006
--------------- ----- -----
T-bills 34% -58%
LongTrm Treas. 37% -54%
Commodities -14% 33%
Small stocks 62% 94%
Hedge funds 35% 96%
Non-U.S. stocks 32% 96%
(Correlation of Asset classes to the S&P 500)
Buffett and Munger dislike Modern Portfolio Theory
At the 2006 Berkshire Hathaway annual shareholders meeting, both Warren Buffett and Charlie Munger expressed their dislike of modern portfolio theory. They also strongly disliked the views of the wizard of Wharton, Jeremy Siegel. In fact, Charlie Munger called it assinine! Strong words from some of the most respected investors in the world. They would rather buy good solid companies with predictable earnings. Well, it's worked for them! I can see their point somewhat- if you want to maximize your returns, just pick the best companies, instead of diluting your investments with companies or assets that are not as good. The problem is, a lot of random events cause unexpected things to happen. In addition, for many people who do not live for reading company reports and balance sheets, it's impractical to expect someone to do the level of research needed to select the best companies. Maybe if Warren would publish a book about how he values companies, that would help out some of the rest of us :)
Diversification and asset allocation will probably not give you the highest possible rate of return, but will give you a reasonable return with reasonable risk. Nevertheless, we should all be open to criticisms of popular investing strategies, as often what works for one time period ceases to work for another. Here's an excellent article discussing flaws of MPT. And here's another article on the criticisms of MPT.
posted by jasonz at
9:03 AM
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